While we acknowledge recession risk has increased, we do not believe a recession is imminent after considering the drivers of this curve flattening.
Global Market Strategist
- All things considered, we are biased towards higher rates, but only marginally higher from current levels
- We believe that the bulk of the repricing for higher rates has already occurred and there are enough reasons that will keep long rates from spiking higher
- Expect the U.S. 10-year yield to end the year between a range of 2.75% to 3.00%
- For investors, we believe that taking a slightly short to more neutral stance in duration is appropriate
U.S. Treasury (UST) yields have moved sharply year-to-date (YTD): nominal 2-year (2Y) and 10-year (10Y) yields have risen by ~185bps and ~110bps respectively, thanks to the Federal Reserve’s (Fed’s) hawkish pivot. At the start of the year, markets anticipated the Fed would deliver roughly three 25bps rate hikes in 2022. Today, markets are expecting close to ten 25bps rate hikes (Exhibit 1). Given that there are only six remaining meetings, the market is effectively pricing in at least two 50bps rate increases as a live possibility. Investors have hence started to consider what the direction of travel might be for rates from here and if the moves in long rates (10Y tenor and up) are fully priced.
Additionally, the spread between the U.S. 2Y and U.S. 10Y Treasury yield has briefly turned negative, signaling an inverted yield curve. This adds to the narrative around growth fears and potentially a recession on the horizon. While we acknowledge recession risk has increased, we do not believe a recession is imminent after considering the drivers of this curve flattening.
Exhibit 1: Market pricing of number of U.S. rate hikes
Number of 25bps rate hikes
Almost all of the moves higher in short end rates (2Y) YTD are attributable to expectations that inflation will be higher in the short term, thanks to supply chain issues and geopolitical tensions. The flattening of the curve has also been overwhelmingly driven by an inverted inflation curve while the real curve remains relatively steep, and studies have shown that this underlying dynamic points to a lower probability of recession than in the past.
Factors supporting higher long rates
Real policy rates
The real neutral rate matters as it is the equilibrium interest rate in the long run that is neither expansionary nor contractionary for economic activity. Real policy rates above or below the real neutral rate would indicate the Fed’s restrictive or accommodative stance, respectively. Many economists have estimated the real neutral rate to be somewhere between 0-50bps, which is in line with the Laubach-Williams latest estimate of ~36bps.
While there has been a lot of chatter on the Fed potentially having to raise nominal rates past the neutral threshold to tighten monetary policy, we note in Exhibit 2 that the market-implied real policy rate trajectory indicates that the real policy stance will not be restrictive until March 2024.
In prior rate hiking cycles, we also note that the real policy rate had typically ended up higher than the real neutral rate estimate (Exhibit 3), taking the real policy stance to restrictive territory. As of today, the market-implied real policy trajectory still looks relatively benign. But should inflation continue to stay elevated, and the Fed sees a need to act more aggressively, the current trajectory would look mispriced. A repricing of the real policy rate trajectory would support rates moving higher from current levels.
Balance sheet reduction / Quantitative Tightening (QT)
All that was gleaned from the March Federal Open Market Committee (FOMC) meeting on the balance sheet was that 1) it would look very familiar to the previous QT experience from 2017-2019 and 2) details of QT would be announced soon, which we think means at the next FOMC meeting on May 4th, with balance sheet reduction commencing in mid-May.
Currently we assume (Exhibits 4 & 5):
- An initial run-off of USD 25bn per month (USD 15bn UST & USD 10bn mortgage-back securities (MBS)) that will ramp up to a maximum run-off of USD 100bn per month (USD 60bn UST & USD 40bn MBS)
- Caps will be increased by USD 25bn per meeting (June: USD 50bn, July: USD 75bn, September: USD 100bn)
The expected reduction in the Fed’s UST and MBS holdings between 2022 and 2024 is estimated to be ~USD 1.56tn and USD 734bn, respectively, which will see a cumulative reduction of the Fed’s balance sheet by ~USD 2.3tn at the end of 2024.
It is difficult to pinpoint how exactly QT affects liquidity and the rates market overall since we have only had one previous round of QT between 2017-2019. The reliability of a statistical sample of one is an issue that comes to mind, but our base case is that QT might lead to a modest upside in rates.
However, should QT ramp up more aggressively than expected, i.e. announcing a run-off without caps, this could lead to a large quantity of bonds maturing within a short time frame which can cause rates to spike higher.
Inflationary pressures persist above what markets expect
Current 5Y inflation breakevens have risen 50bps YTD and now signal CPI will average ~3.4% over the next five years. Should geopolitical tensions persist and continue to impact energy prices and supply chains, markets may readjust for more persistent inflation, pushing up long rates in the process.
Factors that may keep long rates in check
- Inflationary pressures show some signs of receding, particularly some sequential slowing. Should month-over-month (m/m) inflation begin to moderate from the 0.5%-0.6% level to a more normal 0.2-0.3%, markets could take this as a signal inflation is finally cooling down. We illustrated the path to lower inflation in “The glide path to lower inflation”.
- Long rates have already priced in much of the robust economic activity. Rates tend to move alongside shifting economic conditions and the move so far YTD may be capturing most, if not all, of the positive economic surprises. With growth and inflation expected to soften, nominal yields may move lower as well.
- Demand, particularly among well-funded pensions, remains robust. While banks appear to be softening their demand for Treasuries, well-funded pensions may look to de-risk. According to Milliman*, the median top 100 pension plans funded status at the end of February stood at 102.4%, thanks to the dual benefit of rising rates (lowering present-day liabilities) and strong market performance over 2021. Some de-risking could see flows into duration, keeping a lid on rates.
- Forward expectations of longer-term nominal policy rates are trading close to the Fed’s estimate of neutral (2.375% is the median as per the latest Summary of Economic Projections). The 5y5y point of the curve is something we track closely because the 5y point is critical in determining the path of monetary policy and throwing this five years forward gives us a good sense as to where the market thinks interest rates will be over the longer term when policy is assumed to normalize i.e. we call it the market’s estimate of the neutral rate. The gap between the Fed’s and market’s estimate of the neutral rate is about 20bps, much smaller than the average of ~90bps since 2012 when the Fed started providing these estimates. While there is still a gap and the market can overshoot, which will take rates moderately higher from here, market expectations of long rates have already repriced significantly since the beginning of this year when the gap was closer to 85bps.
All things considered, we are biased towards higher rates, but only marginally higher from current levels. We expect the U.S. 10-year yield will end the year between a range of 2.75%-3.00%. That said, geopolitical tensions and a hiking Fed suggest rates will not move in a straight line. In our opinion, the biggest mispricing continues to be in the real policy rate trajectory, especially if the Fed has to step up and be more aggressive in fighting high and persistent inflation. But given our belief that the bulk of rates repricing higher has already occurred, we are advocates for a smaller underweight to duration across multi-asset portfolios.
Against a backdrop of moderately higher rates, we continue to prefer global equities and select credit exposures like U.S. high yield with manageable duration risk and strong corporate fundamentals. A higher rate environment that transpires through the hiking cycle will continue to benefit value vs. growth equities and provides a more constructive outlook for sectors like Financials.